Thursday, October 6, 2011

A couple of years ago my wife and my business partner's wife turned up at our office in Bondi Junction and then went shopping in the mega-mall below.

This is the sort of thing that gives a tight-wad like me nightmares.

A couple of hours later they returned with their bags. My wife was wearing a new perfume which I kind of liked.

I would have told her I liked it even if I was completely indifferent (she is my beloved wife) but I could say it honestly. It was Chanel Gardenia.

This was about a month before our tenth wedding anniversary so I had solved the gift problem – or so I thought. Later I popped down to DJs (think Nordstrom for Australia) and Myer (the also-ran department store) looking for Gardenia. No chance. Eventually a customer took pity on me and told me you could only find this at the Chanel shop.

I could see the bill going up.

I found the Chanel shop in a part of the mall I never visit and the shopkeeper (an elegant woman in high-heels who looked straight through me) eventually showed me the perfume which came only in sizable and expensive bottles. Three minutes later and $230 lighter I had my gift.

Mission accomplished.

Australian labeling laws require that Chanel specify some of the ingredients. Here is the label (now somewhat decayed):

It is a pretentious label. They call water “Aqua”. Guess they can't bring themselves to admit they sell water at almost $1000 per litre. Alcohol is the main ingredient – probably a good proportion of the total. Most the rest I had never heard of.

Being an inquisitive type I looked them up – I even looked on Alibaba for the cost (per tonne) of these chemicals so I could get some idea of how much I was being ripped off by the fancy box and the elegant lady in high-heels. It spoiled the romance but was educational. According to Wikipedia, Citral is a 3,7-dimethyl-2,6-octadienal or lemonal, is either of, or a mixture of, a pair of terpenoids. The E-isomer is known as geraniol (also an ingredient of the perfume). It is pheremonal in insects (and in the hope – probably vain - of the perfume manufacturer pheremonal in humans too). There are lots of suppliers on Alibaba – mostly by the barrel. Most of these are distributors for Givaudan – a Swiss flavors and fragrances business.

Linalool is a major fragrance chemical used – according to Wikipedia – in 60-80 percent of “perfumed hygene products” and also by pest-professionals as an insecticide. (Note what this perfume does – drives insects wild with pheremones and kills them. Think what it can do for you!) Again most the distributors on Alibaba are distributors for Givaudan. You can buy it here for $5 a kilogram and they will sell you 1000 tonnes per month. It is kosher (and Halal) too!

From there I went looking at Givaudan – the company that probably manufactured this fragrant “Aqua”. It is an interesting company with an enormous website containing technical specifications (instructions, FDA approvals etc) for the thousands of flavors and fragrances it manufactures. When you see apple-pie and cheesecake flavored yogurt what you are seeing is their fine Swiss technology. There are - if you do a Google count - about 11 thousand pages on this website. This is a sophisticated and wide-reaching business.

Givaudan is an interesting stock (we think about it as a long) and it is currently trading fairly low relative to sales vis its history. It is the technological leader in flavors and fragrances.

Here is its P&L in Swiss Francs for the past two years...

This company does CHF336 million (almost 400 million dollars) a year in research and development. That is what your cheesecake flavored yogurt and Britany perfume cost to develop. This R&D is a pretty solid barrier to entry. After quite considerable distribution costs (you have to interest the food manufacturer in the bizarre terpanoid you have developed) and considerable R&D Givaudan winds up with operating income of 13.1 percent of sales.

There is another flavors and fragrances company – International Flavors and Fragrances – that used to be the leader and is still the leader in tobacco flavoring (a declining business I would guess). IFF is well known to people who have read the investment classic “Common Stocks and Uncommon Profits”. IFF had a tech leadership for generations and was a fantastic stock - it is still not a bad one. Somehow (I don't know how as I do not have the history) it ceded much of that leadership to Givaudan.

All very interesting and grist for the memory bank.

Recently I came by Huabao – a Chinese flavors and fragrances company listed on the Hong Kong stock exchange. Market cap is about 20 billion Hong Kong dollars - about 2.5 billion USD.

Huabao has a market cap of a bit over a third of Givaudan, and is a strange beast. Like IFF it claims to be primarily a tobacco flavorant. Here is the P&L.

Huabao it seems is a truly miraculous business. Gross profit is over 70 percent. Marketing and distribution expense is 80 million Hong Kong dollars – roughly a twentieth of Givaudan. Research and development expenses are 73 million HKD – a little over 10 million or about a fortieth of Givaudan's expense.

Profit before tax is 1871 million Hong Kong dollars on total sales of 2852 million HK dollars. That is 65 percent of sales and it compares (very) favorably with 13 percent at Givaudan of sales.

I wanted to work out what Huabao actually sold – what R&D they had – what technology they had that justified their superior returns. Alas this was difficult. You see HBGlobal.com is not a very informative website.

Here – in pictures – is the page (yes one page) that describes their product set.

Compare this page to the very detailed specification at Givaudan. HBGlobal does not even allow its product specifications to be indexed on Google. (Go on – look at the page – it is pictures of text, not text, and hence not indexed.)

I went looking for all the chemicals in my wife's perfume on Alibaba. I could not find Huabao as a supplier. Nor could I find HBGlobal.

I googled “+Huabao. +citral” and the core reference I found was to Jishui Huabao Natural Medicated Oil Factory being a buyer of citral. Similar results were obtained for other chemicals.

I did this with lots of combinations of chemicals and the brand names they operated under (at least the brand names they operated under according to the HBGlobal website).

The website states that Kongque is a long established food additives brand in China. Kongque turns up in one index as one of literally 40 pages of suppliers for food flavor additives. Here is their entry which tells you nothing about them but gives a limited range of products (Lecithin, Foodstuff Essence, Flavor, Collagen Protein, Stuff Additives, Trichloromethyl Sucrose, Crystalline Fruit Sugar, Phosphate, Water-retaining). I have no idea what "stuff additives" are - and Trichloromethyl Sucrose is also a strange product - according to some links a sweetener 8000 times as sweet as sugar - but I can't find any non-Chinese references to it. Moreover this claim is likely false: saccharine is usually thought to 300-500 times as sweet as sugar and that is sweeter than most of the other standard sugar substitutes.

This tiny list of lightly specified products does not compare favorably to the sophisticated list at Givaudan.

For the life of me I can't work out what Huabao does that makes it so profitable – I can't work out what chemicals it makes, what products it sells and why it manages to do so with much less research and development than Givaudan (or International Flavors and Fragrances).

Still Huabao must be real. You see it is audited by Price Waterhouse Coopers, it is not a reverse merger and it is listed on the Hong Kong Stock exchange – and we know that the HKSE is far more honest than the reverse mergers in the US. Mr Charles Li, the CEO of the HKSE told us.

So – if any of my readers know more about the flavors and fragrances business than you can get from reading Wikipedia and a perfume label and looking at Alibaba will you let me know.

Please.

Meanwhile – on the basis I can't understand any of this I am short on behalf of my clients. Super-fat margins in a chemical company almost devoid of research and development does not sound very sustainable to me.

My readers are a clever lot – so if you can help me, or talk me out of this position I would be thrilled.

Thanks in advance.

John

Post scripts: Some commentators have suggested that this company is a reverse merger - going public via the back door in 2006. I have not checked.

Also some commentators have suggested that Trichloromethyl Sucrose is the sweetener known in the US under the brand name "splenda". The 8000 times as sweet as sugar statistic sort of matches - and splenda has three chlorine atoms in the structure so cold be "trichloro" as per the name. But I am not sure where the methyls (ie CH3s) come in. There is a structure illustrated here.

28 comments:

Another interesting "fragrance company", if your interested, is Robertet SA. Unfortunately, the company hasn't printed financials in English since 08 and, I believe, it doesn't trade in big volume (my data is questionable so I am not sure).

There. Tobacco flavours being a mature business. You only have to sell to cigarette manufacturers. The flavours have been around for years, the relationships are solid, so low marketing and low research costs.

However, this leaves the margin: why isn't anyone competing with them? IFF for example?

On Huabao: I did some research on Huabao a few years back when it was hot, and ended up owning some shares before it crashed a few months back. I didn't dig deep enough to know for sure if the accounts of the firm were genuine, but the story worked like this:a) The company is the largest(near monopolistic) supplier of cigarette flavoring to most of the big Chinese cigarette makers (all of which are state owned). This is where the extraordinarily high and consistent profit margin comes from.b) it's unclear how the entrepreneurial founder/CEO came about this "golden goose".c) The company started to invest in food flavoring and fragrance business 5-6 years ago, but there is not much to show for so far, as far as I can tell -- other than the Annual Report has gotten a lot "greener" (literally, too).d) At least some of the acquisitions the company did since listing were buying unlisted businesses related to the founder/CEO, at very high valuations. Also, the founder periodically sold her holdings, and often the stock had run-up right before her sales.e) The company's recent decision to go into the more capital-intensive cigarette manufacturing business (some sort of low-tar version, I think) was attributed by "the Street" for its de-rating.f) The company did go public in Hong Kong via the back-door in 2006.

If the company is a fraud as the financials seem to suggest it is, why does it pay a relatively large dividend? That would trouble me if I were short. One could argue that the recent dividends have been financed with debt, but still, why let any cash leave the company at all?

Trichloromethyl is a method for synthesis, its most common use (I would think) would be a cheap way of making chemical weapons. I imagine its big in 3rd world countries who want to synthesise liquid compounds for release into humid air. It's been a while since I've done any sort of practical chemistry, but I'd imagine perfumes may use this kind of technology, and I'd imagine this is a cheap way of doing this.

Perhaps this company is a clever guise for chemical weapons business. Given the world we live in, I'd be leaning long rather than short.

One avenue of research might be to see if some of the previous R&D department heads worked for arms programs (or general research) in China or elsewhere, this is a hunch but it sounds like the type of people they'd hire to be a part of converting this chemicals use into consumer products. They may just be using government cost-cutting tricks from government weapons into consumer products and no one else has picked up on this application yet, hence the margins.

How can you eliminate the possibility that they are following the usual Chinese business model of stealing the IP from Western companies and using corrupt relationships to sell a relatively commodity product to a few state-owned companies at inflated prices? However seedy this scenario is, it's not a scenario in which the shareholders necessarily lose.

Grayleaf... yes, you are correct, Huabao primarily services tobacco clients (80%+ sales/EBIT). I met them back in 2007 and even then, they enunciated their strategy was to focus on tobacco. They've benefited as the industry consolidated; that probably has kept them afloat. While the rest of the world continues to make life difficult for smokers, in China, smoking remains rampant. (All my ex-colleagues who worked in China smoked like chimneys.) Check out another company I met during that period, 3318 (the much smaller China Flavors & Frangrances, USD 575m mkt cap) which is still trading pretty much at March 09 lows and no where near the lofty highs of 2007, having fared much worse than Huabao. I did not like them because they could not explain the R&D process and their patents satisfactorily; I suppose that without the consistent demand from tobacco (Huabao has the lion's share of the customer base and it appears that CF&F has been unable to break in), they weren't really able to break into the customers that the European companies have monopolised on perfumes, food, etc?- KC

The fact they have dividend combined with a poorly described product makes me think they might have a real business, and they don't want you to know what it is. Do they make money by paying bribes for a monopoly supplier position to one or more state owned enterprises? Do they sell illegal clone fragrances to facilitate the huge international business in fake perfume, which copies every aspect of packaging and smell of the original products?

I did find it amusing that the subsidiary's About Us page shows a photo of an aircraft carrier! Maybe there is a military or weapons connection after all:

Mr. HemptonAs a avid reader of your blog, I have to say I am quite disappointed at this post. It has been three months since your post on Charles Li's comment re frauds in the HKex, but what you came up with is a fairly weak case for a short. There are much more rotten stench at many other HK listed Chinese companies.

@persistentone - Hah, excellent. Military connections with the U.S. obviously - we know now where the money comes from - that's a picture of the USS Harry S. Truman http://bit.ly/oIeXKy which is great generic aircraft carrier wallpaper.

I am not so sure that tobacco flavoring is a declining business. In some parts of the world Chewing Tobacco or Smokeless Tobacco or Snuff (or many other names it is called) is a growing business as far as I knew, which is why Atria bought UST a few years ago. These Chewing tobacco comes in many bizarre flavors, and many ex-smokers are taking up Chewing Tobacco to stop smoking.

In norway and Sweden they use Snus still and it is sold in other parts of the world (US also I believe), I have seen when I was in Norway some strange flavors like Mint and Vanilla. Some of my colleagues in Norway were using this stuff several times a day. I believe this is a growing business in Norway and the US also.

My research says that this company was founded 10 years ago by a then 31 year old woman, now a 41 year old "self-made" billionaire. Scratch beneath the surface there and I suspect that you'll find a cozy monopoly controlled by the scion of Maoist royalty.

if you want an interesting short candidate, have a look at Hidili (1393). If you look at the fraud cases in Asia, very often, they have issued $ bonds and or convertible bonds. That is because they need many ways to finance the negative free cash flow. Sinoforest and Chaoda had both. So does Hidili.

Multinationals are not doing tobacco flavoring because of litigation issues. That is why the margin is high. Also, once you sell a flavor to a tobacco co, you supply until that brand of tobacco is discontinued. I'm not a smoker but smokers seem very loyal to a certain kind of cigarettes. Brands won't change flavor until the line is discontinued.It may be more competitive to get new contracts but they should be ok with the ones they have now.

John, thanks for your many posts. Here are a couple of perspectives from someone who works in the cosmetics and fragrances industry.

1. The ingredient listing on the Chanel label is compliant, as it is required to be, with the INCI naming system, see:

http://ec.europa.eu/consumers/sectors/cosmetics/cosing/index_en.htm

If we had the same logic in fine dining you might receive a menu listing including "Ovis Aries protein, Olea Europaea (Olive) Fruit Oil, Rosemarinus Officinalis" etc. Not quite the same romantic connotation as a grilled organic lamb cutlet infused with rosemary oil, is it?

2. Chanel is renowned for the very high quality of its fragrance ingredients:

Finally a company in the HKEX has blew up. Looking forward to see your view on Boshiwa International(1698:HK). I hope you make some money on it!http://www.ft.com/intl/cms/s/0/dd0fbe22-6e59-11e1-b98d-00144feab49a.html

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.